A Basic Guide to Renewable Energy Market and Energy Tax Basics

So What’s the Quick (But Not Dirty)?

A Deficit Restoration Obligation (DRO) is an obligation by a partner in a partnership to restore a negative balance (i.e., a deficit) in its capital account (i.e., its partner account) when the partnership liquidates.  This is generally an obligation that is required by the tax regulations if a partner wants to claim losses or other benefits beyond its capital invested in a partnership. For solar deals, this can also help firm up the allocation of tax credits to a tax equity investor.

How Does It Work?

When a partnership is formed, generally what happens is that the partners will either contribute property or cash into the partnership.  The partnership creates an account (i.e., capital account) to track this investment.  The account goes up and down based on what the partner puts in or pulls out of the partnership.  Claiming losses (and sometimes credits) is treated as pulling something out of the partnership.  The partnership agreement decides how these items are shared among partners.  For example, a partnership agreement can state that cash is to be distributed per the amount of monies contributed, but profits and losses are allocated in proportion to the number of partners; so, in the case of a two-partner partnership, the losses will be allocated 50 percent to each partner.  In a solar deal, profits are normally allocated 99 percent to the tax equity investor in the early years of the partnership, while cash is shared in a different, negotiated ratio.

A problem that arises with this is if allocation of the losses and distribution of cash drag a partner’s capital account below zero.  Under Section 704 of the tax code, a partnership can allocate losses to a partner only to the extent of that partner’s capital account. Thus, the tax rules require losses to be shifted to other partners if allocating a loss to a partner will cause it to have a negative capital account.

Most partnerships do not want the Internal Revenue Service (IRS) coming in to mess with the allocations (Would you want IRS interference in your life?).  Here comes the DRO to help save the day.  So, how exactly does a DRO help?  The tax rules will deem a partner to have a positive capital account (even if technically negative) if the partner agrees to bring the account back to zero in the event of a partnership liquidation.  This allows a partner to avoid having its share of losses shifted away to other partners.  This agreement is the DRO. 

Why Is This Important for Renewable Energy Deals?

Renewable energy deals are based on an investor wanting to contribute capital and enter into a partnership with a sponsor/developer to take advantage of allocations of tax items, such as investment tax credits (ITC) or production tax credits (PTC) and depreciation.  The tax equity investor’s share of these items is typically set at 99 percent to the tax equity partner and 1 percent to the sponsor until a partnership flip occurs.  If a tax equity partner does not agree to a DRO, then a portion of its share of tax losses, which were an incentive for the tax equity investor to initially enter into the deal, will be allocated to the sponsor instead.  To avoid this, the tax equity partner typically agrees to a DRO in the amount needed to maximize its share of losses.  PTCs follow bottom-line income or loss, so, for wind deals, it is important that the DRO match the share of PTCs that the investor expects.  For solar deals, some investors believe that keeping 99 percent of the losses firms up the case that they should be entitled to 99 percent of the ITC.

The DRO should work itself off as the partner is allocated positive profits in the future.  Profit allocations increase a partner’s capital account.  That said, some investors worry that the DRO will not be fully worked off in a timely manner, so they may set an artificially low cap on the size of the DRO that they will entertain.